Big Money vs. Bernanke: Who's Right About the Economy?

By Mohamed A. El-Erian

Reuters

The last few weeks have seen yet more shots fired in the fascinating war of words between the Federal Reserve and hedge fund managers. Yet this spectacle is essentially a sideshow. The real battle is elsewhere. It relates to a Fed that is uncomfortably being boxed in by highly-dependent markets.

For a few months now, quite a few hedge fund managers have complained loudly about the Fed. Their protests reflect the difficulties of investing in manipulated markets which, at times, can be quite "irrational" - at least according to their analytical, historical and mental models. They hate interacting in markets where central banks act both as competitors (with better visibility and information) and referees (seemingly happy to change the rules at a whim).

Hedge funds managers see stock rallies as an end in themselves. Central banks rely on them to grow the economy and create jobs.

Adding to hedge fund anxiety is the fact that, unlike private market participants, central banks can stay a long time in loss-making trades. Indeed, some would argue that, given its role as the issuer of the world's reserve currency, the Fed could remain there forever (absent political intervention). Accordingly, extreme market mis-pricings and artificial correlations can persist longer than traditional hedge fund strategies remain solvent.

After maintaining a stiff upper lip for quite a while, Fed officials have started to talk back. Commenting on the market turmoil that followed the most recent policy announcement, Mr. Richard Fisher, President of the Dallas Fed, cautioned a couple of weeks ago that "big money does organize itself somewhat like feral hogs."

This battle of words will not end anytime soon as it involves two distinct viewpoints - that of commercially-driven (and often impatient) hedge fund managers that treat a market outcome as an end in itself; and those of central banks for whom market outcomes are a means to help achieve macroeconomic outcomes (growth, jobs and inflation).

As the rest of us continue to be entertained by this, we should not lose sight of the fact that the really important battle in this domain is elsewhere. It pits central bankers deep in policy experimental mode (and now desiring greater flexibility) against a much larger group of highly-dependent market participants unable to fathom the possibility of central bankers dis-engaging, even if marginally and incrementally.

This played in May and June when Fed Chairman Ben Bernanke raised the possibility that the Fed may taper its support for markets. In doing so, he went out of his way to make any possible future actions conditional on economic developments. He even mentioned illustrative dates in order to reduce the probability of subsequent shocks to the markets.

Rather that internalize this in a calm manner, markets reacted as if Fed tapering were immediate and dramatic.

Levered investors jumped to unwind carry trades, and did so in a rather disorderly fashion. Dealers lost their appetite for risk-taking, withdrawing liquidity and intermediation services. End investors headed for the doors, pulling billions out of bond and equity mutual funds.

Faced with heightened risk of market malfunction that would undermine the real economy, central bankers were forced to walk back on what, after all, was quite mild tapering talk. One after the other downplayed any immediate policy change, also noting that tapering was only "one possible outcome."

All this would not be a problem if the current policy stance could be maintained for a long time and was likely to succeed as is. Unfortunately both are problematic.

As Bernanke himself recognized back in August 2010, unconventional Fed policy involves a delicate balance of "benefits, costs and risks." Given the transmission mechanisms involved, the longer the policy persists, the higher the probability of collateral damage and unintended consequences.

The Fed is increasingly constrained. Its experimental policies have created conditions that make both the status quo and potential changes increasingly and uncomfortably messy.

Acting on its own, it is hard to see how the Fed can resolve this impasse while also meeting its economic objectives. It urgently needs the help of those institutionally equipped to deliver a more comprehensive policy approach that deals with the three problems of insufficient aggregate demand, inadequate structural reforms and pockets of debt overhangs.

For that, Washington will need to overcome its current phase of polarization and dysfunction. In the meantime, and regardless of the war of words with hedge funds, the Fed is likely to feel even more boxed in.